E(NGDP) level-path targeting for the people of the concrete steppes

"But what concrete steps will the Fed actually take to raise Nominal GDP? Can anyone tell me that?"

I must have heard that question a hundred times over the last couple of years. And a dozen more times in the last day, ever since Paul Krugman endorsed the proposal to target NGDP. I always imagine it being asked in a gruff Yorkshire accent, by some middle-aged no-nonsense practical man of business with a background in mechanical engineering.

So this is written for the people of the concrete steppes.

First off, you aren't thinking about this right.

Sure, I've used mechanical metaphors for monetary policy in the past. But those metaphors only take you so far. Machines don't have expectations; people do. The actions that people take now depend very much on their expectations of what other people will do, and on their expectations of what the central bank will do.

You want me to tell you a story in which the central bank pulls a lever, and that lever causes another lever to move next, followed by another lever, then another, spelling out a causal chain from beginning to end, where the end is a higher level of NGDP.

But economics isn't like that. Because people aren't like that.

Sometimes the future causes the present, because people's expectations of the future affect what they do in the present.

Sometimes it's not even what will happen in the future that causes the present. It's people's expectations of what would happen in future if they behaved differently today that causes them to behave the way they do today. I switch to snow tires in the Fall because I expect I would have an accident in the Winter if I didn't. It's the threat of an accident that makes me put on snow tires. I don't actually expect to have an accident.

Next week, millions of Canadians will get up and go to work about one hour later than they did this week, if we measure time by the sun. "What concrete steps will the government take to get Canadians to do this? Can anybody tell me that?"

No, I can't tell you that. I don't have a clue what concrete steps, if any, the government will take. But I fully expect it will work. All the government does is announce that it wants us all to do this, and to put all our clocks back one hour. Maybe the government has the power to force government clocks back one hour, and force some government workers to start and leave work one hour later by the sun. But the rest of us just follow along, simply because we expect everyone else to follow along.

There will be two groups of people who will continue to get up at the same time by the sun. People who didn't get the memo (and most of them will follow along with a short lag). And people who live very isolated lives, whose timing doesn't depend on what everyone else is doing.

Driving on the right side of the road is an equilibrium. If you expect everyone else to drive right, you too will drive right. Driving on the left side of the road is also an equilibrium. If you announce that beginning Sunday everybody will switch to driving on the left, and if people believe you, or simply believe that other people believe you...everybody will switch to driving on the left. You don't actually have to pull any levers. All you need is credibility. Or people to believe you have credibility. Or believe that others believe you have credibility.

The US economy is currently in equilibrium. It's not a market-clearing equilibrium. It's not a very good equilibrium. But it is an equilibrium. If it wasn't an equilibrium, it would be somewhere else. But it isn't somewhere else, so it must be. Given what people expect other people to do, both now and in the future, each person is choosing to do what he is currently doing.

But this isn't the only possible equilibrium. I can imagine a better equilibrium, in which Nominal GDP is higher and growing faster, and expected to remain higher and growing faster. NGPG is higher and growing faster both because real GDP is higher and growing faster and because prices are higher and growing faster. It's a better equilibrium. And those of us who advocate E(NGDP) level-path targeting want the US economy to move to that better equilibrium.

What would the Fed be doing differently, in that other, better equilibrium? The Fed will be smaller than it is today, and the Fed's interest rate will be higher than it is today. Real interest rates will need to be higher, because consumption and investment demand will be higher, because consumers and investors will have higher expectations of future real income and real expenditure. Nominal interest rates will be higher because prices are expected to be growing faster. The Fed will be smaller, because people won't want to hold as much money, and banks won't want to hold as many reserves at the Fed, now the economy is growing and interest rates are higher.

So, all the Fed needs to do to get the economy to that new, better equilibrium is to pull the lever in the right direction, right? Raise interest rates, and reduce the money supply, right?

Of course not. If the Fed did that, without changing expectations, the result would be a a move even further away from the better equilibrium, as demand fell even further.

The Fed needs to change expectations. Get people to expect that NGDP will follow the higher path. That's what the "E" in "E(NGDP)" stands for.

"Right!" the people from the concrete steppes exclaim gruffly "and how exactly will the Fed do that?!"

1. The Fed clearly announces its target path for NGDP. That's by far the most important bit. Everything else is secondary. And if the Fed had credibility, that would be enough.

"Why should anyone believe the Fed can hit that path?"

2. The Fed makes a threat. On the first day the Fed will print $1 billion and use it to buy assets. On the second day the Fed will print $2 billion and use it to buy assets. On the third day the Fed will print $4 billion and use it to buy assets. And the Fed will keep on doubling the amount it prints and buys daily, forever and ever, until E(NGDP) rises to the target path. (And will go into reverse and sells assets if E(NGDP) rises above the target path).

"What assets will the Fed buy?"

3. The Fed puts on its best James Dean (oops, Marlon Brando, thanks Andy) voice and replies: "What have you got?"

There are two rooms at a party. The first room is nearly empty. The second room is nearly full. Because everyone wants to be where everyone else is. Then Chuck Norris enters the second room. He threatens to beat up 1 person at random in the first minute, 2 people in the second minute, 4 people in the third minute, and so on, until the room is empty. This is no longer an equilibrium.

A few people were nearly indifferent to being in the second room. So they leave even if the chance of them getting beaten up is tiny. That means there are fewer people left in the second room. This makes the second room slightly less attractive for those who want to be where everyone else is. And it slightly raises the probability of being beaten up by Chuck Norris. So more leave. Which repeats the process, so still more leave. And if you and I can see what's coming, so can the people in the room, who don't want to be the last to leave. There's a rush for the exits, and Chuck doesn't even have to lift a finger. OK, if someone didn't hear the threat, or doesn't recognise Chuck Norris, he might actually have to carry out his threat for a few minutes. But simply seeing all the others leave the room will be enough to induce most to leave the room very quickly.

Chuck Norris doesn't have to beat up everyone in the room. He just has to threaten to beat up as many as it takes to clear the room. The number of people he will actually beat up is a lot less than the number he threatens to beat up. If his threat is credible, and everyone hears it, he doesn't need to beat up anyone.

Eventually, if the Fed bought up every single asset in the economy, and swapped it for cash, NGDP would rise to the Fed's target path. Prices would rise without limit as the Fed bought up the last remaining assets because the sellers could name their price. And people would hire the unemployed to build factories which they could float on the stock and bond markets and sell to the Fed at any price they liked. Or sell to the people who had already sold all their assets to the Fed.

But there is no way it would ever get that far. That's like saying that Chuck Norris will eventually beat up everyone in the room. That's not an equilibrium.

Some people are just barely willing to hold cash in the current equilibrium. If they expect even the slightest rise in NGDP in even the distant future, they will get out of cash, and into real assets, or claims on real assets like commercial stocks and bonds. And this will increase the demand for goods today, either directly, or because firms find it easier to issue new stocks and bonds to finance investment. Which raises NGDP, and expected future NGDP, even if just a little. Which encourages additional people to exit cash too, and buy real assets and claims to real assets. Which raises NGDP and expected future NGDP still further. And so on. As soon as people figure out what's going on, and what's going to happen, expected NGDP rises to the target path. The Fed only has to carry out its threat until people catch on to what's happening. Then it has to reverse course and sell all the assets it bought, and then some more, to prevent the economy overshooting the new equilibrium.

Want me to make it more concrete still? OK. Here's the New Keynesian version:

Eventually, if it carries out its threat for long enough, NGDP will eventually rise. Some people figure this out. Maybe only a few. They expect either a rise in the future price level or a rise in future real income, or a bit of both. If they expect a rise in the future price level, that means lower real interest rates for given nominal interest rates. That encourages current consumption and investment demand. If they expect a rise in future real income, that also encourages current consumption demand and current investment demand. (People consume more today if they expect to have higher real income in future; firms invest more today if they think there will be bigger demand for the extra goods that will help them produce in future.) So current consumption and investment demand rises, which increases current NGDP.

The more slow-witted people and firms see that rise in current NGDP, and spend more on consumption and investment, and also revise upwards their expectations of future NGDP, which causes an additional rise in consumption and investment and NGDP.

More people begin to figure out that maybe the Fed's target is credible after all.

And so on.

Oh, and if you believe in the debt-deleveraging hypothesis, there's an additional channel. Higher expected future NGDP makes it easier to handle a given debt load, by reducing future expected debt/income ratios.

Update: I really want people to read a triad of very good posts by Bill Woolsey: his response to thoughts on NGDP targeting by Paul Krugman; Brad DeLong; and Steve Williamson. Bill lays out clearly some of the issues about how NGDP level path targeting works.

Comments

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Nick, judging by comments here is hardly a selection bias and is more likely to reflect the quality of idea than anything else. If people who do want to understand it fail to understand then 99.9% of population will simply ignore it. Their attention is limited by 10 seconds which will not be enough to explain what E or N in E(NGDP) mean. It is foreign language.

So, yes, I am very sceptical (but I hope I know what E and even N mean) but I do try to understand it. And what I miss from the E story is that it works through delta's. When Chuck Norris enters the room and threatens to beat everybody up, the delta is easily observable. That is the flow is people leaving the room. As people leave the room and everybody can clearly observe the delta and the validity of the threat, the expectations about being beaten up are adjusted. But when the central bank starts speaking some foreign language which most people do not understand what will trigger adjustments to their expectations? What is that delta that is easily observable? If you said lets Fed target S&P500 then it would be easily observable and we could discuss whether it will trickle down. But what is NGDP? How can anybody reasonably observe it? Moreover if the Fed fails to reach its NGDP target in the first period, how can anybody reasonably believe that threat is real in the second and other periods?

Nick: if you want to use a dictionary in which "monetary policy" is defined in such a way that the probability of monetary policy happening is zero.....OK. But I'm not going to use that same dictionary myself

It is not about dictionary because there is no continuum between fiscal and monetary. The probability of monetary policy is not zero but 100% if the Fed buys government bonds in the primary market (the market with pretty much daily activity) and holds them to maturity. Then it is purely monetary. We can also argue that short-term repos in OMO and buying bonds in the primary are very close substitutes and therefore OMO's are monetary operations as well. But if the Fed starts buying random stuff with unclear future p&l effects and therefore potentially subsidizing/taxing private sector as a result of particular operations with particular assets than it is not monetary. It is fiscal because it is equivalent to the Fed buying bonds from Treasury in the primary market (purely monetary operation) and Treasury buying whatever Fed wanted to buy with direct fiscal subsidizes or taxes to the given asset / private agent.

Sergei: "If you said lets Fed target S&P500 then it would be easily observable and we could discuss whether it will trickle down. But what is NGDP? How can anybody reasonably observe it?"

I tend to agree with you on that point. Scott Sumner suggests setting up an NGDP futures market. If that is done, then E(NGDP) would also be observable, and my guess/hope is that financial journalists would look at it and say "Hey look, E(NGDP) is up, which means the Fed's policy is working and people are becoming more optimistic, blah, blah...".

When you speak negatively about wealth redistribution, you imply that wealth distribution itself is not part of the problem.

The trouble is many, many people think wealth distribution is part of the problem.

Second, NGDP futures markets are fanciful constructs. If I recall correctly Abba Lerner proposed just this kind of market in the late 1970's but his idea was to sell the rights to price increases in order to control inflation.

His proposal and NDP Futures markets fail because they provide no concrete, tangible micro benefit. They do not allow you to lock in apple prices in April for sale in October, by way of comparison. At a micro level they are pure speculation.

That kind of speculation has been known to be dubious since the 1770's when the UK passed the Gambling Act, also known as the Life Insurance Act. Life Insurance is a hedge, but people were buying life insurance policies on celebrities as a form of gambling. The law then said that you couldn't insure something that you don't have a direct economic interest in, something that will cause you a direct loss.

I am very wary of proposals to have monetary policy set by the actions of speculators.

Determinant: some people say we should transfer income from rich to poor now, because we want to reduce saving and increase demand. Will those same people at some future time, when we want to increase saving and reduce demand, say we should transfer income from poor to rich? They won't.

In reality the former poor, now richer, place themselves into higher tax brackets with their increasing incomes. And the money continues on downhill to those who are poorer still.

Who says the operation has to be reversed at all? If we wish to reduce demand, we can raise taxes or raise interest rates, both of which we know work really well at reducing demand but have had trouble recently increasing it.

Perhaps people want to live in a more equal society, period.

We can have a production capacity-constrained economy (a supply constrained economy) or a money-constrained economy. The tools that work in one don't work in the other. We believe the economy is currently money-constrained, not supply-constrained. We want to change that state. Once we do, our tools will change as well. Therefore what is done will not necessarily be undone by the same tool.

Or perhaps people feel that the rich have better opportunities to increase their earning potential than the poor do. They want to turn that around so that the poor have better chances of increasing their incomes and by larger percentages than the rich. They want a diminishing return to being rich, not an increasing one.

But why are economists uncomfortable with politics at all? Economics has been inextricably intertwined with politics since Marx & Engels published the Communist Manifesto and that only redoubled when Keynes' General Theory came on the scene. And then we have Hayek and Friedman who both did politics, or did I misunderstand The Road to Serfdom and Free to Choose?

Apolitical macro is an oxymoron. It doesn't exist. I'm comfortable with those warts.

Nick: "Some people say we should transfer income from rich to poor now, because we want to reduce saving and increase demand. Will those same people at some future time, when we want to increase saving and reduce demand, say we should transfer income from poor to rich?"

They don't have to. Every few years we'll have a systemic crisis and provide a huge bailout to the financial sector. But seriously, Nick, the economy is rife with rents and rent seekers. Some of the monopolies are natural, and lots of them are enforced by our crony, clientilist government overlords. In the midst of the most severe economic downturn in over 70 years we didn't have a single quarter of net negative quarterly corporate profits. After taxes! Does that sound like the equilibrium of an efficient market? You can't model the macro economy correctly at all without a very large Dixit-Stiglitz rent aggregate.

Anyways, I'm not advocating regulating the economy via tuning of the Gini coefficient. Personally I think inequality is best tackled by rationalizing regulations that produce rents (inequality of access to central banking, excessive IP protections, regulatory burdens that protect incumbents, etc) or directly taxing those rents (land, negative externalities), cutting back government, and distributing a citizen's dividend. But there may be debt/deflation type liquidity traps where many agents are so deeply insolvent, that the inevitable solution will require a wealth transfer (either directly or via significant inflation).

"It came exactly two months before Christmas, with retailers preparing for the holiday shopping season, their busiest. Almost twice as many people now expect a pay cut over the next six months as expect a raise."

And, "The survey found that a growing number of Americans are worried about making less money over the next six months. The proportion of people expecting a pay cut is about nine percentage points higher than those who expect a raise, the biggest gap since April 2009, Oubina said."

Problem: "The index is based on a survey conducted Oct. 1-13 of about 500 randomly selected people nationwide."

"Why did Ben and Rosengren broach the subject of the Fed becoming less accommodative? We believe the reason is the reacceleration of inflation as evinced by PPI and CPI, as well as Americans’ view that inflation is far worse than what CPI suggests."

And, "A recent article stated that the Fed will now take food and energy prices more seriously because average Americans are irate at the real inflation in the necessities of life and don’t buy the Core bs."

And, "GDP is a bogus and deeply flawed economic indicator. As we keep ranting, real income and real living standards are the best and foremost economic indicators.

A Long, Steep Drop for Americans’ Standard of Living

The standard of living for Americans has fallen longer and more steeply over the past three years than at any time since the US government began recording it five decades ago.

Bottom line: The average individual now has $1,315 less in disposable income than he or she did three years ago at the onset of the Great Recession – even though the recession ended, technically speaking, in mid-2009…Per capita disposal personal income – a key indicator of the standard of living – peaked in the spring of 2008, at $33,794 (measured as after-tax income). As of the second quarter of 2011, it was $32,479 – almost a 4 percent drop… http://www.cnbc.com/id/44962589

With a more realistic accounting for inflation, living standards and real income would be much worst. We have maintained for years that tax data yields a far worse jobs and income picture than the BLS’s jobs report and other government agencies’ income data because tax data is actual receipts and not guesses, surveying, modeling, hedonic and seasonally adjusted garbage. Americans Grow More Negative About Their Personal Finances Nearly half say their financial situation is “getting worse,” similar to early 2008 Nearly half (48%) say their personal financial situation is “getting worse,” up from 41% in April and nearly tying the record-high 49% who said so in April 2008. www.gallup.com

Source:
The King Report
M. Ramsey King Securities, Inc.
October 20, 2011 – Issue 4121 “Independent View of the News”"

What if most people have wage growth below price growth and believe that will continue in the future? How will they react?

"K: I like to think of the tax/transfer system as the proper tool to deal with long run micro distributional questions, and monetary policy as the proper tool for short run macro stabilisation policy."

Nick: "I like to think of the tax/transfer system as the proper tool to deal with long run micro distributional questions, and monetary policy as the proper tool for short run macro stabilisation policy."

Me too. I hope that was clear from my comment. Let's work toward a system that does that. In the meanwhile I am not at all confident that central banks have anywhere near the necessary means to bring us out of some disequilibria. If the fiscal authority has to help out, I won't object if it does so in a manner that provides some redress for some of the most egregious recent injustices.

Nick: "I tend to agree with you on that point. Scott Sumner suggests setting up an NGDP futures market"

Looks like I need to read about that though my gut feeling tells me that this futures market is no solution again. Again for 99.9% this futures market is foreign language. Anyways, I have two more questions re basics.

GDP is a flow concept which requires time dimension and N is a specific type of aggregation over the chosen time period. This aggregation depends on the level of prices and on the real product. So now you have three dimensions but one variable that you try to control. This means that you can arrive at the given NGDP in many ways. How do you differentiate (and is it required at all) between the following obvious three scenarios:
a. price level and production increase steadily (your desired scenario?)
b. at the beginning of the period price level jumps (say doubles) and product falls (say by 10%) and then both slowly trend to the NGDP target and reach it by the end of the period
c. nothing happens until one day before the end of the period but then price level goes to infinity

Obviously the ending position of the given period matters for the development of NGDP in the next period. How do you solve the problem of time-dependency (path-dependency) if you target variable (NGDP) is loosing information?

The second question is re "E" in the E(NGDP). Different private sector agents will have different positions with regards to the behaviour of N in the NGDP. Some agents are by definition "short" inflation (which we can roughly say is equivalent to N in the NGDP) and some are "long". In the credit economy with private sector credit *only* both short and long positions sum up to zero on the macro level. This aggregation however masks the distribution of the risk tolerance with respect to NGDP. Those who are "short" inflation can have higher or lower aggregated risk tolerance then those who are "long" inflation. Obviously, in the private credit economy *with state money* the net position is different from 0 and you try to appeal to it with NGDP targeting.

So my question is simple: why do you think that the Fed buying random stuff will skew the aggregated risk tolerance in the right direction with regards to the NGDP target? I can envision exactly the opposite scenario where NGDP targeting and Fed buying random stuff will push the E part of NGDP in the adverse direction because the risk tolerance and its distribution is such that spending *now* on the *expectations* of the future (on the aggregated level, i.e. eliminating risk tolerance and its distribution) will be irrational.

Determinant: some people say we should transfer income from rich to poor now, because we want to reduce saving and increase demand. Will those same people at some future time, when we want to increase saving and reduce demand, say we should transfer income from poor to rich? They won't.

How does this statement square with claims that critics of mainstream economics misrepresent the political beliefs of economists?

Your b and c could be problems in principle, and would be problems in practice if we measured NGDP per *decade* (say), but I'm not worried about them in practice at (say) a quarterly frequency. Stuff doesn't jump around that much that quickly. (Seasonality might be an issue, but it's an issue with almost anything, and we can more or less deal with it.)

Your a is what the debate has been about. NGDP=PxQ (where P and Q are vectors). One alternative to NGDP targeting is Price level path targeting. (Which is targeting the path of P, rather than PxQ). (And inflation targeting is targeting the rate of change of P). It's not obvious which is best. We argue about it. The main arguments in favour of NGDP rather than P are: it works better with supply shocks; P tends to respond more slowly than Q, so targeting NGDP is more responsive to what's happening.

Mandos: do you know anyone who says we should transfer from rich to poor when AD is too low and transfer from poor to rich when demand is too high? I don't. I would respect the philosophical integrity of such a person, even if I thought they were a bit daft.

I know lots of people who say we should always transfer from rich to poor, and find some other way to control demand. Most economists fit this category, even if they argue among themselves about how much should be transferred and how best to control demand.

Mandos: do you know anyone who says we should transfer from rich to poor when AD is too low and transfer from poor to rich when demand is too high? I don't. I would respect the philosophical integrity of such a person, even if I thought they were a bit daft.

I know lots of people who say we should always transfer from rich to poor, and find some other way to control demand. Most economists fit this category, even if they argue among themselves about how much should be transferred and how best to control demand.

That's not how you put it above, though. It read to me like you thought believe in one was contingent on the other. Transferring from rich to poor (difficult to implement because of the political control of the rich, but whatever) and controlling demand (I assume, for environmental purposes or something...) post hoc doesn't sound nearly as odd to me, in itself.

I do. It's hard for me to sustain fire and brimstone and jeremiads...in the afternoon! Yes, it's the afternoon where I am now. Afternoon is naptime for me, except I don't know how to nap. So I just sag at my desk.

Nick,
for a start I think targeting NGDP rather than inflation (or inflation/unemployment) is a good thing to do.

I don't think it would have helped too much now though. Because if inflation doesn't also include asset prices something crucial is missing. (True though it would force the Central to try very hard to stimulate the economy if it ends up in a liquidity trap. It is just that fiscal policy is better at spreading the money throughout the economy (especially if the monetary authorities monetarise it) than pushing on a string is - no matter how hard you push on the string.) You can't just say to people - there will be inflation tomorrow and expect large numbers of them to start spending madly - when most of them are broke and have hardly any income. Spreading the money works faster.

But what happens if the trend real growth rate fall (for instance consider Germany and Japan and the consequences of demography - not to mention resource depletion) - or if you suffer from a massive terms of trade change? Could once off price adjustments be treated as inflation/deflation. Any rule will be wrong sometimes. Rules are for the guidence of wise men and the obedience of fools.

And reading Max's comment made me aware of something else - the fairness issue. Using quantitive easing aggessively means subsidising the market. But the market is rich. Why is subsidising those who need it least a good thing to do?

Nick Rowe: "some people say we should transfer income from rich to poor now, because we want to reduce saving and increase demand. Will those same people at some future time, when we want to increase saving and reduce demand, say we should transfer income from poor to rich? They won't."

I am not one of those people who say that we should transfer income from rich to poor to increase demand. However, the transfer of income from poor to rich already happens. There is no need to legislate it any more than it is already legislated.

Steve: in economics, the term "equilibrium" has come to mean "the time path that the model predicts". You could argue that it is vacuous, but if we have an interactive model it's hard to avoid using the term. The point I was trying to make is that when people say "monetary policy won't move the economy, because even if it does exert a force there is some other force pushing in the opposite direction" (which I hear all the time) the people making that argument are confusing "moving" with "moving relative to where it would have gone otherwise".